Remember this time last year? The markets opened with a nosedive in Chinese stocks. By the time New York came in for trading, China was already down 7% and trading had been halted. That started, what turned out to be, the worst opening stretch of a New Year in the history of the U.S. stock market.
The sirens were sounding and people were gripping for what they thought was going to be a disastrous year. And then, later that month, oil slid from the mid $30s to the mid $20s and finally people began to realize it wasn’t China they should be worried about, it was oil. The oil price crash was a ticking time bomb, about to unleash mass bankruptcies on the energy industry and threaten a “round two” of global financial crisis.
What happened? Central banks stepped in. On February 11th, the Bank of Japan intervened in the currency markets, buying dollars/selling yen. What did they do with those dollars? They must have bought oil, in one form or another. Oil bottomed that day. China soon followed with a move to boost bank lending, relieving some fears of a global liquidity crunch. The ECB upped its QE program and cut rates. And then the Fed followed up by taking two of their projected four rate hikes off of the table (of which they ended up moving just once on the year).
What a difference a year makes.
There’s a clear shift in the environment, away from a world on liquidity-driven life support/ and toward structural, growth-oriented change.
With that, there’s a growing sense of optimism in the air that we haven’t seenin ten years. Even many of the pros that have constantly been waiting for the next “shoe to drop” (for years) have gone quiet.
Global markets have started the year behaving very well. And despite the near tripling from the 2009 bottom in the stock market, money is just in the early stages of moving out of bonds and cash, and back into stocks. Following the election in November, we are coming into the year with TWO consecutive record monthly inflows into the U.S. stock market based on ETF flows from November and December.
The tone has been set by U.S. markets, and we should see the rest of the world start to play catch up (including emerging markets). But this development was already underway before the election.
Remember, I talked about European stocks quite a bit back in October. While U.S. stocks have soared to new record highs, German stocks have lagged dramatically and have offered one of the more compelling opportunities.
Here’s the chart we looked at back in October, where I said “after being down more than 20% earlier this year, German stocks are within 1.5% of turning green on the year, and technically breaking to the upside“…
And here’s the latest chart…
You can see, as you look to the far right of the chart, it’s been on a tear. Adding fuel to that fire, the eurozone economic data is beginning to show signs that a big bounce may be coming. A pop in U.S. growth would only bolster that.
And a big bounce back in euro zone growth this year would be a very valuabledefense against another populist backlash against the establishment (first Grexit, then Brexit, then Trump). Nationalist movements in Germany and France are huge threats to the EU and euro (the common currency). Another round of potential break-up of the euro would be destabilizing for the global economy.
With that, as we enter the year with the ammunition to end the decade long economy rut, there are still hurdles to overcome. Along with Trump/China frictions, the French and German elections are the other clear and present dangers ahead that could dull the efficacy of Trumponomics.
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The last big market event of the year will be Wednesday, when the Fed decides on rates.
As we’ve discussed, from the bottom in rates earlier this year, the interest rate market has had an enormous move. That has a lot of people worried about 1) a tightening that has already taken place in the credit markets, and 2) the potential drag it may have on what has been an improving recovery. But remember, we headed into the Fed’s first post-crisis rate hike, last December, with the 10 year yield trading at 2.25%.
And while rates have since done a nearly 100 basis point round trip, we’ll head into this week’s meeting with the 10 year trading around 2.50%. With that, the market has simply priced-in the rate hike this week, and importantly, is sending the message that the economy can handle it.
However, what has been the risk, going into this meeting, is the potential for the Fed to overreact on the interest rate outlook in response to the pro-growth inititiaves coming from the Trump administration. As we found last year, overly optimistic guidance from the Fed has a tightening effect in this environment. People began bracing ealier this year for a slower economy, if not a Fed induced recession, after the Fed projected four rate hikes this year.
The good news is, as we discussed last week, the two voting Fed members that were marched out in front of cameras last week, both toed the line of Yellen’s communications strategy, expressing caution and a slow and reactive path of rate hikes (no hint of a bubbling up of optimism). Again, that should keep the equities train moving in the positive direction through the year end.
In fact, both equities and oil look poised to take advantage of thin holiday markets. We may see a few more percentage points added to stocks before New Years, especially given the catalyst of the Trump tweet. And we may very well see a drift up to $60 in oil in a thin market.
We’ve had the first production cut from OPEC in eight years. And as of this weekend, we have an agreement by non-OPEC producers to cut oil production too. That gapped oil prices higher to open the week, and has confirmed a clean long term technical reversal pattern in oil.
This is a classic inverse head and shoulders pattern in oil. The break of the neckline today projects a move to $77. Some of the best and most informed oil traders in the world have been predicting that area for oil prices since this past summer.
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Oil popped over $3 from the lows of the day (as much as 7%) on news OPEC has agreed to a production cut.
We’ve talked a lot throughout the year about the price of oil. When it collapsed to the $20s, it put the entire energy industry on bankruptcy watch.
Of course, oil bounced sharply from those lows of February as central banks stepped in with a coordinated response to stabilize confidence. Not so coincidentally, oil bottomed the same day the Bank of Japan intervened in the currency markets.
The oil price bust all started back in November of 2014, the evening of Thanksgiving Day, when OPEC pulled the rug out from under the oil market by vowing not to make production cuts, in an attempt to crush the nascent shale industry. At that time, oil was trading around $73.
You can see in this chart, it never saw that price again.
OPEC was successful in heavily damaging the U.S. shale industry through low oil prices, but it has damaged OPEC countries, too.
What will the news of an agreement on a production cut mean?
A policy shift from OPEC can be very powerful. In 1986, the mere hint of an OPEC policy move sent oil up 50% in just 24 hours. And as we discussed earlier in the year, the relationship between the price of oil and stocks this year has been tight. At times, stocks have traded almost tick for tick with oil.
Take a look at this chart.
An oil price back in the $60s would be a catalyst for a big run in stocks into the year end. For a stock market that has been rudderless surrounding a confused Fed and an important election, this oil news could kick it into gear.
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The debate last night was entertaining. It’s sad to see how the media manipulates facts and cherry picks quotes to fit their narrative.
But that’s what they do and it ultimately shapes views for voters, unfortunately.
Today, I want to focus on China and Trump’s comments on China’s currency manipulation. Everyone knows the U.S. has lost jobs to China. Everyone knows China has become the world’s manufacturer. But not everyone knows how they did it.
Is it just because the labor is so cheap? Or is there more to it?
There’s more to it. A lot more.
China’s biggest and most effective tool is and always has been its currency. China ascended to the second largest economy in the world over the past two decades by massively devaluing its currency, and then pegging it at ultra–cheap levels.
Take a look at this chart …
In this chart, the rising line represents a weaker Chinese yuan and a stronger U.S. dollar. You can see from the early 80s to the mid 90s, the value of the yuan declined dramatically, an 82% decline against the dollar. They trashed their currency for economic advantage – and it worked, big time. And it worked because the rest of the world stood by and let it happen.
For the next decade, the Chinese pegged their currency against the dollar at 8.29 yuan per dollar (a dollar buys 8.29 yuan).
With the massive devaluation of the 80s into the early 90s, and then the peg through 2005, the Chinese economy exploded in size. It enabled China to corner the world’s export market, and suck jobs and foreign currency out of the developed world. This is precisely what Donald Trump is alluding to when he says “China is stealing from us.”
Their economy went from $350 billion to $3.5 trillion through 2005, making it the third largest economy in the world.
This next chart is U.S. GDP during the same period. You can see the incredible ground gained by the Chinese on the U.S. through this period of mass currency manipulation.
And because they’ve undercut the world on price, they’ve become the world’s Wal-Mart (sellers to everyone) and have accumulated a mountain for foreign currency as a result. China is the holder of the largest foreign currency reserves in the world, at over $3 trillion dollars (mostly U.S. dollars). What do they do with those dollars? They buy U.S. Treasuries, keeping rates low, so that U.S. consumers can borrow cheap and buy more of their goods – adding to their mountain of currency reserves, adding to their wealth and depleting the U.S. of wealth (and the cycle continues).
The U.S. woke up in 2005, and started threatening tariffs against Chinese goods unless they abandoned their cheap currency policies. China finally conceded (sort of). They agreed to abandon the peg to the dollar, and to start appreciating their currency.
They allowed the currency to strengthen by about 4.5% a year from 2005 through 2013. That might sound good, but that was a drop in the bucket compared to the double digit pace the Chinese economy was growing at through most of that period. Still, the U.S. passively threatened along the way, but allowed it to continue.
With that, the Chinese economy has ascended to the second largest economy in the world now – on pace to the biggest soon (though it still has just an eight of the per capita GDP as the U.S.). But China’s currency is a bigger threat, at this stage, than just the emergence of China as an economic power. The G-20 (the group of the world’s top 20 economies) has had China’s weak currency policy at the top of its list of concerns for a reason.
The current global imbalances are the underlying cause of the global financial crisis, and China’s currency is at the heart of it.
And without a more fairly valued yuan, repairing those imbalances — those lopsided economies too dependent upon either exports or imports — isn’t going to happen. It’s a recipe for more cycles of booms and busts … and with greater frequency.
Are big tariffs the answer? Historically that’s a recipe for disaster, economically and geopolitically.
What’s the solution? I’ve thought that the Bank of Japan will ultimately crush the value of the yen, as the answer to Japan’s multi-decade economic malaise and as an answer to the stagnant global economic recovery. It’s an answer for everyone, except China. A much weaker yen could crush the China threat, by displacing China as the world’s exporter.
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Since Friday of last week, there have been a lot of reports on the spike in the VIX. Today I want to talk about the VIX and the performance of major benchmark markets over the past week.
In a world where stability is king, central bankers have been very sensitive to swings in key financial markets, with the idea that confidence and the perception of stability can quickly become unhinged by market moves. When that happens, it becomes a big, viable threat to the global economic recovery and outlook. It can certainly send policy intentions off of the rails (as we’ve seen happen time and time again with the Fed).
Should they be worried?
With the above said, some might think the biggest threat to a Fed move in September (or December) isn’t economic data, but this chart.
Sources: Reuters, Forbes Billionaire’s Portfolio
First, what is the VIX? The VIX is an index that tracks the implied volatility of the S&P 500 index. What is implied volatility? It’s not actual volatility as might be measured by the dispersion of data from is mean.
Implied vol has more to do with the level of certainty that market makers have or don’t have about the future. When big money managers come calling for an option to hedge against potential downside in stocks, a market maker on the floor in Chicago at the CME prices the option with some objective inputs. And the variable input is implied volatility. When uncertainty is rising, the implied volatility value includes some premium over actual volatility. In short, if you’re a market maker and you think there is rising risk for a (as an example) a sharp decline in stocks, you will charge the buyer of that protection more, just as an insurance company would charge a client more for a homeowners policy in an area more included to see hurricanes.
So with that in mind, the implied vol market for the S&P 500 had been very subdued for the past 45 days or so, quickly falling back to complacency levels following the Brexit fears of late June. But since Friday, when market interest rates on government bonds spiked sharply (in the U.S., German, Japan), the VIX spiked from 12 to 20 (a more than 60% move).
That indicates a couple of things: 1) Stock investors were spooked by the move in rates and immediately looked for some downside protection, and 2) market makers aren’t quite as complacent as they appeared when the VIX was muddling along at low levels. They are quick to raise the insurance premium, highly spooked by the risk of a sharp decline in stocks.
But it looks like this recent spike might have more to do with market maker community that is psychologically damaged by the abrupt market moves of the past eight years. Gold is down since Friday – giving the opposite message of what the VIX is giving us about perceived uncertainty (people smell fear, they buy gold). And the S&P 500 has only lost 1.3% from its peak last Friday.
We headed into the weekend with a market that was spooked by a sharp run up in global yields. On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.
On the latter two, both German and Japanese yields had been deeply in negative yield territory. And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.
But in just three days, the tide turned. On Friday, German yields closed above the zero line for the first time since June 23rd. Guess what day that was?
Brexit.
And Japanese 10-year yields had traveled as low as 33 basis points. And in a little more than a month, it has all swung back sharply. As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.
So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher? Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?
Here’s why.
First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy. As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower. But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations). Because the market began pricing in a better economic outlook, given the Fed’s actions.
With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.
That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).
Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.
Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%. As of last week, it was trading closer to 1.50%. That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates. Don’t worry, rates are still very, very low.
Still, the biggest risk to the stability of the bond market is, positioning: The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike. That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.
As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy. But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.
Bottom line: The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.
The Fed’s Janet Yellen was the focal point for markets for the week. She had a scheduled speech at the annual Fed conference at Jackson Hole.
When her speech was finally made public Friday morning, the response in markets was uncertainty (the most used word for the past nine years).
Stocks went up, then down. Yields went down, then up.
So what do we make of it? Let’s start with the headlines that hit the wire Friday morning.
The world was wondering if Yellen would support the messaging from some of her fellow Fed members–that a September rate hike is on the table. Or would she continue the backstepping (dovish speak) the Fed has done for the past five months. The answer was ‘yes.’ She did both.
Yellen said the case for rate hikes has strengthened (yellow marker) because the data is nearing their goals (employment and inflation–the white marker). Ah, rate hike. But then she said the Fed expects inflation to hit the target 2% in the next few years (circled)! And then talked about the strategy for more QE. Huh? And then to top it off, she said they might move the goalposts. They might move the inflation target higher, and start targeting GDP. That means they would be happy to leave conditions ultra accommodative until those higher targets are met. Clearly dovish.
As I said Thursday, they want to raise rates to get the financial system closer to proper functioning, but they don’t want to cause a recession. The Fed wants to raise short-term rates, but promote a flatter yield curve (i.e. promote expectations that the economy will continue to be soft) to keep the market interest rates low, which keeps the housing market on the rails and the economic activity on the rails.
Remember, we talked about the piece Bernanke wrote a couple of weeks ago, where he suggested exactly this type of perception manipulation from the Fed, to balance the need to raise rates, without killing the economy.
That looks like the game plan.
Have a great weekend!
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We’ve talked about the recent public portfolio disclosures that have made in recent days by the world’s biggest investors.
And as we’ve discussed, the 13F filings only offer value to the extent that there is some skilled analysis applied. Loads of managers file 13Fs every quarter. And the difference in manager talent, strategies, portfolio sizes … run the gamut.
Through our research of over 15 years, among the most predictive factors in these filings is the presence of high conviction positions. To put it simply, the bigger the position relative to the size of their portfolio, the better. Concentrated positions show conviction. Conviction tends to result in a higher probability of success, especially when the investor has a controlling stake and is influencing (or seeking to influence) management. At that stage, these positions will show up first, before the quarterly 13F filing, in more timely filings called a 13D (or 13G) filings.
Here’s a look at a specific case that fits that profile, with some detail on why it matters.
If we look across high conviction positions among the recent 13F filings, among the highest, we find Carmike Cinemas (symbol CKEC). Mittleman Brothers, a $410 million hedge fund and value investment advisor, runs a concentrated portfolio, and owns 9.6% of the CKEC.
The stake represents (as of the most recent 13F filing) more than 31% of its long U.S. equity portfolio (more than 18% of its overall portfolio). That’s a huge stake.
After fees the Mittleman Brothers have returned 17% annualized since inception (2003). So we have a manager that has doubled the S&P 500 over the 14 years, runs a concentrated portfolio, and has an ultra-high conviction stock in CKEC. And in this particular case, they have the ability to influence the outcome in CKEC.
The fund filed a 13D on Carmike back in March, which means they intended to influence management. Mittleman has since been trying to block a sale of Carmike to AMC Entertainment Holdings for a value they deem “unacceptably low.”
At the time of the first takeover offer, the stock traded at just around $25 (so a $30 takeout would be a 20% premium). The stock now trades at $31. But based on industry multiples, Mittleman argues the company should be sold for no less than $40, and as much as $47. The bid has since been raised, but remains at levels Mittleman has deemed unacceptable.
The moral of the story: As we know, management’s mandate in public companies is to maximize shareholder value, but unfortunately it doesn’t always happen (most of the time, only after their interests are maximized). That’s why siding with influential shareholders that are fighting to maximize your return on investment is critical. In the case of Carmike, you have management that is willing to give away the company for as little as 70 cents on the dollar (according to view of one of its biggest shareholders).
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Yesterday we talked about the bullish technical breakout shaping up in stocks. Today we want to talk about a very quiet bull market going on that supports the story for stocks. It’s commodities.
Within the course of the past four short months, commodities have gone being the leading threat for global stocks, to being a leading indicator of an emerging bull cycle for stocks.
Oil, of course, was the key culprit earlier in the year. At $26 oil the world was a scary place. The dominoes were lining up for widespread bankruptcies, starting in the energy complex and spreading to financials, sovereigns, etc.
If you recall, back in early February we said in our daily notes, “OPEC is not just in a price war with U.S. shale producers, but it’s playing a game of chicken with the global economy. We’ve had plenty of events over the past seven years that have shaken confidence and have given markets a shakeup – European sovereign debt, Greece potentially leaving the euro, among them. In Europe, we clearly saw the solution. It was intervention. Oil prices are creating every bit as big a threat as Europe was, we expect intervention to be the solution this time as well.”
Indeed, central banks stepped in and removed the risk with a slew of intervention tactics ranging from more QE from Europe, currency intervention from Japan, relaxing reserve requirements in China, to the Fed removing the prospects of two (of what was projected to be four) rate hikes this year.
That was the dead bottom in oil (which started with BOJ action in USDJPY). And it kicked broader commodities into gear, many of which had already bottomed weeks prior. No surprise, commodity stocks have been among the best performing stocks in the world for the past four months.
Now we have oil closing above $50 today, for the first time since July of last year. And remember, two of the best oil traders of all time have been calling for oil to trade between $80 and $100 by next year (both Pierre Andurand and Andy Hall).
We looked at this chart in our April 12th piece and said: “technically, oil looks like a technical breakout is here. In the above chart, you can see oil breaking above the high of March 22 (which was $41.90). In fact, we get a close above that level — technically bullish. And we also now have a technically bullish pattern (an impulsive C–wave of an Elliott Wave structure) that projects a move to $51.50, which happens to be right about where this big trendline comes in.”
You can see we’ve not only hit this trendline and gotten very close to that projection from April, but (not as easy to see in this chart) we have a clear break of this downtrend now. That line now comes in at $49.39. Oil last traded $50.49.
Next is a look at broader commodities. But first, we want to revisit the clues we were getting from commodities back in early March. Here’s what we said in our March 3rd note: “There are other very compelling signs that the global economy is not only backing away from the edge but maybe turning the corner.
It’s all being led by metals prices. Copper is often an early indicator of economic cycles. People love to say copper has ‘has a Ph.D. in economics’ because it tends to top early at economic peaks and bottom early at economic troughs. Copper bottomed on January 15 and is up 13% since.
The value of iron ore, another key industrial metal, has been destroyed in the past five years – down 80%. That metal bottomed quietly in December and is up 32% since.”
The Goldman Sachs commodity index is now up 44% from the bottom, though it’s heavily weighted energy. The more diversified CRB index is up 24%. Both would fall into the bull market category for those that like to define bull and bear markets. But bottom line, when you look at the above chart you can see how deeply depressed commodities have been. The trend is broken, and the model signals for big trend followers are flashing all over the place to be long. And as we said yesterday, in early stages of cyclical bull trends in stocks, energy does the best by far. With that, although the energy sector weathered a life threatening storm, the upside remains very big for the survivors.
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As we discussed earlier in the week, market participants are trained to be fixated on the monthly jobs data. That was evident in today’s market reaction, as it always is. The payroll number, the number professional investors have been trained to trade, was weak this morning. The unemployment number, on the other hand, was at best levels since November 2007.
In normal times, the jobs data is probably the single most informative data point, where you can see signals of heating up or cooling down in the economy. But of course, we haven’t been in a “normal” economy in a long time.
Still, in recent years, the U.S. jobs data has remained, bar none, the biggest single data point in the world. Why? Because the Fed explicitly told us that they wanted to see the unemployment rate at 6% before they would consider the first steps of removing emergency policies. And because the Fed was the Captain of the globally concerted policies that saved the global economy from an apocalypse, the Fed was also broadly depended upon to lead the world OUT of emergency policies.
But even after seeing dramatic improvements in the key jobs data that the Fed was targeting, meeting the target and then exceeded the target, they have still been very slow on the path of “normalization.”
Now they’ve told us the jobs data are in a good place, relative to their current policy position (i.e. rates should be, not normal, but quite a bit higher by now). But the Fed has run into other obstacles they didn’t foresee when they began their “jobs targeting” campaign: 1) they underestimated the deflationary impact of the global debt crisis, 2) somewhat related, they underestimated the lack of leverage on wages employees would have in dramatically improved job market, and 2) they underestimated the weakness in the global economy and the vulnerability of the U.S. economy to shocks outside of the U.S.
Broadly speaking, the Fed’s rate decision and, consequently, their message to the world about their confidence in the economy going forward, hasn’t been about jobs for a while. With that, the hyper-focus that market participants continue to give to the data every month seems to be wildly misplaced (for now).
So when we see a weak payroll number, as we did this morning, and the knee-jerk selling from the professional trading community sends stocks lower, Treasuries higher and the dollar lower, it’s probably a good idea to use those moves as opportunities to enter at better levels (i.e. buy stocks, buy the dollar, sell Treasuries).
If we step back a bit and think about the bigger picture, we have a Fed that is considering rate hikes because the economy is doing better (emerging from crisis and robust enough to withstand the removal of emergency policies).
And, as we said, the Fed is leading the way, globally. That is a very positive message for stocks and a very negative message for Treasuries (i.e. rates are going higher, prices will be going lower). As for the dollar, we have a Fed going one way, and Europe and Japan going a distinctly opposite direction (full-throttle QE). That’s squarely positive for the dollar as capital flows away from easing policies (Europe and Japan) and toward yield (U.S. assets).
